VMware’s Stock Can Drive Further if It Is Out of Reverse

A lid on the shares of VMWare and its tracking stock is about to be lifted if
Dell Technologies,
which controls the virtualization software company, decides against pursuing a reverse merger with
VMware.

Shares of VMWare and the tracking stock both rose today after Bloomberg reported late Friday that Dell was leaning against such a merger. At midday today, shares of VMware (ticker: VMW) were up 7%, to $130, while the tracking stock, Dell Technologies, class V, (DVMT), was up 3%, at $75.

Investors may now believe that Dell will go public in a traditional initial public offering rather than pursue a reverse merger in which VMware would issue stock to the private Dell and allow Dell to go public that way.

Given VMware’s impressive business and financial outlook, that means more upside for its shares and appreciation potential as well in the tracking stock.

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The tracker, which is designed to reflect the economic performance of VMware, trades at a near-record discount of 43% to the VMware. The tracker discount was about 35% before early February, when Dell surprised Wall Street by announcing that it was considering a combination with VMware or an initial public offering, as well as no action.

Dell declined to comment on the Bloomberg report. But if Dell goes public in an initial public offering, it would be able to redeem the tracking stock at a 20% premium for the first year after the IPO, declining to 15% in the second year and 10% thereafter.

While the tracker would no longer be tied to VMware in such a scenario, the tracker holders presumably would get some premium for their shares and they also could benefit from a higher VMware share price if Dell chooses to go public. If Dell has an IPO, VMware presumably would be unaffected or Dell could offer to buy out the public holders of VMware – likely at a premium.

VMware, meanwhile, trades at a sharp discount to peers, including
Red Hat
(RHT), reflecting Dell’s 82% ownership of the company and fears that a debt-heavy Dell will act in its own interests and not those of VMware.

A reverse merger involving Dell and VMware was viewed by VMware investors and analysts as the worst possible scenario among the three considered by Dell. Morgan Stanley analyst Keith Weiss warned that VMware stock could decline sharply if Dell pursues the reverse merger.

“The proposed Dell-VMW reverse merger has previously drawn public opposition by VMW shareholders, due to the slow-growth, legacy nature of Dell’s core business as well as its heavy debt load,” he added “We believe this is incrementally positive for VMW but look for an official update,” He has an Outperform rating and a price target of $140.

Two larger VMware shareholders, including T. Rowe Price, the leading independent holder, have come out against a Dell/VMware combination, arguing that it would be disruptive to VMware and change the complexion of the software company. There also reportedly has been strong opposition to a reverse merger inside VMware.

VMware trades for about 21 times projected adjusted earnings in its fiscal year ending in January 2019, roughly half the multiple of Red Hat. VMware looks even cheaper when considering that it has around $20 a share in net cash on its balance sheet. And VMware is expected to generate about $3 billion of free cash flow this year, or nearly $8 a share, putting its valuation at closer to 16 to 17 times forward free cash flow – a reasonable price by current software standards.

Deutsche Bank analyst Karl Keirstead has been bullish on both VMware and the tracking stock partly because he has put lower odds on a reverse merger than others on Wall Street. He has Buy ratings on both VMware, with a price target of $175, and the tracking stock, with a price target of $114.

While Dell has said it is in “excellent financial condition,” Wall Street has viewed the company’s consideration of a reverse merger with VMware as a sign of weakness because such a deal would give a debt-laden Dell full control of VMware’s ample free cash flow, which Dell can’t now access because VMware pays no dividend. Dell ended its fiscal year with $48.7 billion of debt but it calculated “core debt” -- excluding borrowings at its finance unit and elsewhere in its capital structure -- at $39.9 billion.

Dell, which took on a large debt load when it acquired EMC in 2016, may announce a decision on VMware in the next two weeks ahead of a major conference called Dell Technologies World 2018 that will be held in Las Vegas starting on April 30.

The decision will be made by Michael Dell, in conjunction with Dell’s other major equity holder, Silver Lake Partners.

Given it debt load and challenges in its database business, Dell would be tricky to value in an IPO. There might not be a lot of equity value in Dell after reflecting its debt load.

That may be the motivator for Dell to consider a reverse merger with VMware in which Dell would effectively put a price on its business. Dell’s core earnings before interest, taxes, depreciation and amortization, excluding VMware, is running at about $5 billion annually. One reason for Dell to go public would be to offer liquidity to Silver Lake, which originally invested in Dell’s leveraged buyout in 2013.

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